An investment setting in which price behavior responds to, and is driven by, changes in investor risk tolerance. Risk-on risk-off (RORO) refers to changes in investment activity in response to global economic patterns. During periods when risk is perceived as low, risk-on risk-off theory states that investors tend to engage in higher-risk investments (risk on). When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments (risk off).
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The effect of the Risk On, Risk Off Trade is to cause asset correlation to become more positive.
Since the financial crises in 2008 there has been a growing trend of investors, particularly institutional investors, to buy risk (risk on) when inflation is the leading prospect for the economy and sell risk (risk off) when deflation is the leading prospect for the economy.
Risk On = Long: Stocks, Commodity Currencies (Australian/Canadian/New Zealand), Energy & Food Commodities. Short or Avoid: Bonds, Non-Commodity Currencies including the U.S. Dollar.
Risk Off = Long: High Quality Bonds (U.S. Treasuries), Non-Commodity Currencies including the U.S. Dollar. Short or Avoid: Stocks, Commodities, and Commodity Currencies (Australian/Canadian/New Zealand).
The theoretical basis
for the Risk Trade is the tug of war between inflationary and deflationary forces. When inflationary forces are perceived as gaining ground, then risk on. When deflationary forces are perceived as gaining ground, then risk off.
The effect of the Risk On, Risk Off Trade is greater volatility and more importantly greater asset correlation. The mass movement of large institutions and investors all in
or all out
of asset classes has caused many assets to become highly correlated.
See also: http://lexicon.ft.com/Term?term=risk-on,-risk-off